class: center, middle, inverse, title-slide .title[ # Principles of Microeconomics ] .author[ ### ECO 2306 ] .date[ ### <em>Fall 2022</em> ] --- class: center, middle, inverse # Chapter 4: Economic Efficiency, Government Price Setting, and Taxes --- ## Chapter Overview - Markets bring buyers and sellers together by setting equilibrium prices which determine equilibrium quantity - But is this a good or bad thing? Maybe more/less is better? - What measurement will we use to determine whether equilibria are desirable? - Economists use the idea of “surplus” to refer to the benefit that people derive from engaging in market transactions. - **Consumer surplus** is the difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer pays. - **Producer surplus** is the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. --- ## Consumer Surplus: Deriving demand .pull-left[ - Assume that we have four people: Theresa, Tom, Terri, and Tim - They love chai, but value it differently according to the schedule - We can characterize them by the highest price they are willing to pay - At what price will no chai be sold? - How many cups will be sold at $4.50? - How much benefit do the potential tea consumers derive from this market? - That depends on the price and their **marginal benefit**, the additional benefit to a consumer from consuming one more unit of a good or service - If the price is low, many of the consumers benefit - If the price is high, few (if any) of the consumers benefit ] .pull-right[  ] --- ## Consumer Surplus: Measuring consumer surplus .pull-left[ - If the price of tea is $3.50 per cup, Theresa, Tom, and Terri will buy a cup. - What is Theresa's consumer surplus (net benefit)? ] .pull-right[  ] --- ## Consumer Surplus: Measuring consumer surplus .pull-left[ - If we apply the same logic to Tom and Terri we see their consumer surpluses represented by areas B and C - Tom's consumer surplus: $5-3.50 = $1.50 - Terri's consumer surplus: $4-3.50 = $0.50 - So how do we find the consumer surplus of the chai tea market? ] -- .pull-right[  ] --- ## Consumer surplus: Example Jim Bob needs a new banjo--the cigar box banjo just isn't cutting it anymore. Jim Bob has decided he is willing to pay $150 for a new banjo but finds one for $75. What is his consumer surplus from this purchase? -- $$ \$150 - 75 = \$75 $$ --- ## Producer Surplus: Overview - Demand curves show what? <!-- willingness of consumers to by a product at different prices --> -- - Supply curves similarly show willingness of firms to show supply a product at different prices -- - How willing is the firm? - Depends on the **marginal cost** of producing the product - **Marginal cost**: the additional cost to a firm of producing one more unit of a good or service -- - **Producer surplus** - the difference between the lowest price a firm would accept for a good or service and the price it actually receives - analogous to consumer surplus --- ## Producer Surplus: Deriving Supply .pull-left[ - Heavenly Tea is a (very small) producer of chai tea. - When the market price of tea is $2.00, Heavenly Tea receives producer surplus of - $0.75 on the first cup (the area of rectangle A), - $0.50 on the second cup (rectangle B), and - $0.25 on the third cup (rectangle C) ] .pull-right[  ] --- ## Producer Surplus: Total Producer Surplus .pull-left[ - So how do we calculate the total producer surplus? - Total producer surplus is equal to the area above the supply curve and below the market price of $2.00 ] -- .pull-right[  ] --- ## Efficiency of Competitive Markets .panelset[ .panel[.panel-name[Overview] - A market is efficient if: 1. all trades take place where the **marginal benefit** (MB) equals the **marginal cost** (MC) 2. it maximizes the sum of consumer surplus and producer surplus (i.e. the total net benefit to consumers and firms), known as the **economic surplus**. - *Efficiency* is - maximization of total economic surplus - a criterion to judge whether outcome is good/bad ] .panel[.panel-name[Competitive Equilibrium] .pull-left[ - **Market equilibria** in perfectly competitive markets are desirable because they maximize total economic surplus - Recall that the demand curve represents the marginal benefit schedule, and the supply curve represents the marginal cost schedule - **Efficiency** is that point where the true social marginal benefits equals the true social marginal costs, which perfectly competitive markets pick coincidentally ] .pull-right[  ] ] .panel[.panel-name[Economic Surplus] .pull-left[ - The figure shows the economic surplus (the sum of consumer surplus and producer surplus) in the market for chai tea. - At the competitive equilibrium quantity, the economic surplus is maximized. - Our two concepts of economic efficiency result in the same level of output! ] .pull-right[  ] ] .panel[.panel-name[DWL] .pull-left[ When the price of chai tea is $2.20 instead of $2.00, consumer surplus declines from an amount equal to the sum of areas A, B, and C to just area A. Producer surplus increases from the sum of areas D and E to the sum of areas B and D. Economic surplus decreases by the sum of areas C and E. **Deadweight loss**: the reduction in economic surplus resulting from a market not being in competitive equilibrium ] .pull-right[  ] ] .panel[.panel-name[_] .pull-left[ The reduction in economic surplus resulting from a market not being in competitive equilibrium is known as **deadweight loss**. Deadweight loss can be thought of as the amount of *inefficiency* in a market. In competitive equilibrium, deadweight loss is zero. ] .pull-right[  ] ] ] --- ## Government Intervention .panelset[ .panel[.panel-name[Floors/Ceilings] ### Price Floors vs. Price Ceilings - **Price ceiling**: a legally determined maximum price that sellers may charge - **Price floor**: a legally determined minimum price that sellers may receive - Examples: - Minimum wages - Rent controls - Agricultural price controls ] <!-- NOTE: USE SCOTT'S NOTES HERE!!!!!!!!!!!! --> .panel[.panel-name[Floors] <img src="data:image/png;base64,#images/fig_4_8.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Minimum Wage] <img src="data:image/png;base64,#images/min_wage.png" width="60%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Ceilings] <img src="data:image/png;base64,#images/fig_4_9.png" width="60%" style="display: block; margin: auto;" /> <!--  --> ] .panel[.panel-name[Externalities] - **Externality**: a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services involved - **Black market**: a market in which buying and selling take place at prices that violate government price regulations - **Peer-to-peer** - When a government imposes price controls: - Some people are made better off, - Some people are made worse off, and - The economy is generally inefficient, as deadweight loss will generally occur. ] .panel[.panel-name[Discussion] ### Positive and Normative Analysis of Price Ceilings/Floors Economic analysis can demonstrate that price ceilings and price floors decrease economic efficiency. In light of our discussion today, does this mean they are bad? <!-- Because this is a normative question, it does not have a right or wrong answer; it depends on our values and judgments. --> <!-- It is possible to value the gains from these policies more than the losses. --> ] ] --- ## Price Gouging .panelset[ .panel[.panel-name[Short Run] .pull-left[ - COVID-19 (early 2020) - Shortages (e.g. hand sanitizer, disinfectant wipes, and toilet paper) - What happened to prices? - Short run? - Medium run? - Long run? ] .pull-right[  ] ] .panel[.panel-name[Medium Run] .pull-left[ - COVID-19 (early 2020) - Shortages (e.g. hand sanitizer, disinfectant wipes, and toilet paper) - What happened to prices? - Short run? - Medium run? - Long run? ] .pull-right[  ] ] .panel[.panel-name[Long Run] What happens in the long run in the hand sanitizer market? We would expect producers to respond to the new higher demand for hand sanitizers with permanently higher output. Price would eventually settle back to the pre-pandemic level of $3.99 per bottle. This assumes the marginal cost of production does not permanently increase and goes back to pre-pandemic levels. ] ] --- ## Review: Government Intervention What is economic efficiency? Is everyone better off at competitive equilibrium? -- - Economic efficiency is . . . - a market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum - Note, this does not mean that every individual is better off if a market is at competitive equilibrium - We saw that some producers were made better of by the price floor - We are saying that total surplus is higher under the competitive market equilibrium - Note that the greater producer surplus under the price floor we saw was just caused by transfers of surplus from consumers - It's the elimination of deadweight loss that is the source of the greater total surplus --- ## Taxes .panelset[ .panel[.panel-name[Overview] - What are taxes? - "Taxes are what we pay for a civilized society" - Supreme Court Justice Oliver Wendell Holmes - The primary method by which governments fund their activities - Example: The U. S. Federal government imposes an excise tax of 18.4 cents per gallon of gasoline as of 2021. - Issue: taxes affect the market equilibrium for the taxed good/service - Who pays? - Buyer/seller? - **Tax incidence**: the actual division of the burden of a tax between buyers and sellers in a market ] .panel[.panel-name[MC] <!--  --> <img src="data:image/png;base64,#images/fig_4_10.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[New Equilibrium] <!--  --> <img src="data:image/png;base64,#images/fig_4_10b.png" width="60%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Surplus/DWL] <!--  --> <img src="data:image/png;base64,#images/fig_4_10c.png" width="60%" style="display: block; margin: auto;" /> ] ] --- ## Taxes .panelset[ .panel[.panel-name[Burden vs. Incidence] - **Excess burden**: deadweight loss from a tax - What makes one tax preferred over another? - A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises - This means that we can figure out whether a tax is good or bad relative to others - **Tax incidence** - the actual division of the burden of a tax between buyers and sellers in a market. - How is it determined? - **NOT** whoever has the legal obligation to pay the tax - It's determined by the supply and demand curve, not who is targeted, as we will see <!-- - e.g.: Let's say that the government taxes employers $2.65 per hour worked for Social Security. --> <!-- - It stands to reason, then, that the burden of the tax falls on firms, right? --> <!-- - Wrong --> <!-- - The burden is the same regardless of whether the government taxes firms or employees --> ] .panel[.panel-name[Sellers] ### Collect Tax from Sellers <!--  --> <img src="data:image/png;base64,#images/fig_4_11.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Buyers] ### Collect Tax from Buyers <!--  --> <img src="data:image/png;base64,#images/fig_4_12.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Determinants] ### What determines tax incidence? - Relative slopes of the demand and supply curves - A steep demand curve - buyers do not change how much they buy when the price changes - this results in them taking on much of the burden of the tax - A shallow demand curve - buyers change how much they buy a lot when the price changes - then they could not be forced to accept as much of the burden of the tax - Similar analysis applies for sellers. ] ] --- ## Equations Suppose that the demand for apartments in New York City is $$ Q^D = 4,750,000 - 1,000P $$ -- and the supply of apartments is $$ Q^S = -1,000,000+1,300P $$ -- In equilibrium we know that $$ Q^D = Q^S $$ *This is known as the **equilibrium condition**.* --- ## Equations: Equilibrium Price We know: $$ `\begin{aligned} Q^D &= 4,750,000 - 1,000P\\ Q^S &= -1,000,000 + 1,300P\\ Q^D &= Q^S \end{aligned}` $$ -- So plug and chug! $$ `\begin{aligned} Q^D &= Q^S\\ 4,750,000 - 1,000P &= -1,000,000 + 1,300P\\ 5,750,000 &= 2,300P\\ P &= \frac{5,750,000}{2,300}\\ P^*&= \$ 2,500 \end{aligned}` $$ --- ## Equations: Equilibrium Quantity We know: $$ `\begin{aligned} Q^D &= 4,750,000 - 1,000P\\ Q^S &= -1,000,000 + 1,300P\\ Q^D &= Q^S \end{aligned}` $$ So plug `\(P^*\)` into either quantity eq., to get: $$ `\begin{aligned} Q^D &= 4,750,000 - 1,000(2,500)\\ Q^*&= 2,250,000\\ \\ Q^S&= -1,000,000 + 1,300(2,500\\ Q^*&= 2,250,000 \end{aligned}` $$ --- ## Graph it! .panelset[ .panel[.panel-name[Eq'm/Intercept] <!--  --> <img src="data:image/png;base64,#images/fig_4a_1.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Surplus] <!--  --> <img src="data:image/png;base64,#images/fig_4a_1b.png" width="50%" style="display: block; margin: auto;" /> ] ] --- ## Price Ceiling Example .panelset[ .panel[.panel-name[Rent ceiling] .pull-left[ Suppose the city imposes a rent ceiling of $1,500 per month. - Calculate the quantity of apartments that will be rented - Find the price on the demand curve when the quantity of apartments is 950,000 ] .pull-right[] ] .panel[.panel-name[DWL] .pull-left[ Now the graph can guide our numerical estimates of the economic effects of the rent controls. Calculate the deadweight loss ] .pull-right[] ] .panel[.panel-name[Consumer surplus] .pull-left[ Recall CS was $2,531.25 What is CS with rent control? ] .pull-right[] ] .panel[.panel-name[Producer Surplus] .pull-left[ - PS is analogous to CS - Producers lose area A ($950 million) and area C ($650 million); - they originally had a surplus of $1,947.375 million, - so now producer surplus is: $$ 1,947.375-(950+650) = $347.375 million $$ ] .pull-right[] ] ] ---